Mortgage Forgiveness Presents Challenges in Housing Recovery

Deeply indebted homeowners with government-backed mortgages may have a fresh shot at receiving meaningful mortgage relief, but it will likely come with strings attached.

Earlier this week, President Obama nominated House Financial Services Committee member Mel Watt (D-N.C.) to head the Federal Housing Finance Agency, the regulator of Fannie Mae and Freddie Mac.

If confirmed, Watt, as the regulator of the agencies that guarantee nearly 60 percent of the U.S. mortgage market and back nine out of ten new mortgage loans, would have a major say on various aspects of government housing policy, including the $180 billion dollar question of what to do with the bailed-out mortgage giants.

Dump DeMarco Campaign Wins

While his confirmation is by no means certain—analysts expect stiff opposition from Senate Republicans—Watt's nomination has been welcomed by consumer activists who have been calling for the removal of current FHFA acting director Edward DeMarco.

DeMarco has come under attack over the past year for opposing principal modifications, a contentious form of mortgage relief.

Proponents of principal reduction believe it is the most effective form of mortgage relief for deeply underwater borrowers—those who owe more than their homes are worth.

Forgiving a portion of the principal not only cuts borrowers' monthly payments, but unlike other forms of modification, also helps borrowers regain some equity in their homes. This increases their willingness to continue making loan payments, lowering the probability of a default.

DeMarco, however, has resisted pressure from the Administration to reduce principal on mortgages under the Home Affordable Modification Program (HAMP), even after the FHFA's own analysis showed that principal reductions would result in $1.7 billion in savings to taxpayers.

On principle, he argued that principal reductions were unfair as it punished borrowers who continued to make their mortgage payments despite being underwater. As the conservator charged with minimizing losses to the taxpayer, he said the program would be too costly to administer and could encourage "strategic defaults" by borrowers hoping to take advantage of the program. The costs outweighed the benefits, he concluded.

While private-label investors have increasingly embraced principal forgiveness as a relief option, the housing giants' failure to participate has meant that fewer borrowers have been able to benefit from this form of relief.

Watt has been a supporter of principal forgiveness, so this option may be back on the table for Fannie and Freddie if he is confirmed.

Watt's nomination also coincided with the release of a report from the Congressional Budget Office this week that said implementing a principal forgiveness program at Fannie Mae and Freddie Mac could, under one option, generate as much as $2.8 billion in taxpayer savings.

But it remains to be seen if Watt changes his stance once he becomes director of the FHFA. In an interview with The Wall Street Journal, Watt said that he might reach the same conclusion as DeMarco. He wasn't even sure if principal reductions should even be on the agenda.

"I don't know what the timing would be of when I would get over there. It might be an issue whose time has already passed. And there may be information that would lead me to the same conclusion that they have already reached, if the issue is still a timely issue to consider. I don't know how I would come down on that," he told the newspaper.

Principal Reductions as a "Valuable Tool"

If the FHFA under Watt decides to institute principal reductions, it will still have to be "very careful about how the policy is implemented," warns Laurie Goodman, a noted mortgage analyst at Amherst Securities. The program would require tight "gating" to ensure that principal reductions would be made "only to borrowers who are still very likely to default even with some improvement in the housing market," Goodman said in an interview Thursday.

Goodman herself is a major supporter of principal reductions as a modification alternative.

In a study last year, the analyst showed that principal reductions conducted on non-government or private-label mortgages in recent years have demonstrated a lower re-default rate compared to other mortgage assistance options such as interest rate reductions or capitalization of interest payments.

For 2011 modifications, for example, the re-default rate after 12 months for principal forgiveness was 12 percent, compared to 23 percent for rate modifications and 30 percent for capitalization modifications, according to the report.

The FHFA's failure to adopt principal reductions has come at a huge opportunity cost, according to Goodman, as an earlier implementation of the policy could have prevented more defaults.

Principal reductions, however, remain a "very valuable tool," she said. While the housing revival has meant better recoveries for distressed properties, foreclosure still remains a very expensive process for banks and investors. "A successful modification is a better alternative," she said.

Still, she concedes that DeMarco's concerns about moral hazard— where borrowers strategically default in order to become eligible for principal forgiveness—is not unjustified.

Moral Hazard an Issue

"It has always been a challenge and it becomes even more of a challenge in a housing recovery," said Goodman.

The reason why mortgage investors and lenders are often unwilling to reduce principal on the mortgage, but are more willing to ease other terms, is because the borrower often gets the complete upside from the arrangement.

He gets to lower his payment and stay in his home, while the bank takes a loss. Then when the housing market turns higher, he is able to sell his home at a price higher than the loan amount and gets to pocket the difference.

Now with housing on the mend, the upside from rising prices could provide an even greater incentive to strategically default.

But Goodman believes there are ways to implement the policy while addressing the problem of strategic defaults.

One way would be to ensure that the option is available only to borrowers who are already delinquent at the time of the program's announcement.

"The best way to start a GSE principal reduction program would be to apply it to seriously delinquent borrowers who are substantially underwater. There is no moral hazard if the borrower is already seriously delinquent," said Goodman.

But because principal reduction is an effective tool in preventing future defaults, Goodman has also suggested implementing a "shared appreciation" model that would require borrowers to give up some of their property appreciation in return for a principal reduction.

Shared Appreciation Gains Favor

For example, "In exchange for a write-down of the mortgage to 110 or 115 LTV [loan-to-value ratio], the borrower agrees to give up, say, 50% of the upside," Goodman suggested in her analysis last year.

"A borrower at a 120 LTV would not find this option attractive, as he is giving up half the future upside in exchange for a small principal reduction. A borrower at 150 LTV, who is likely to default anyway, is likely to think a principal write-down to 110 or 115 LTV is a great deal; the write-down is significant and it keeps him in his home."

Ocwen Financial is one company that has experimented with shared appreciation, requiring borrowers to forgo 25 percent of the appreciation in the market.

It is a model that private investors are increasingly likely to adopt as the housing market recovers.

Last week, a bill was introduced in the House to establish pilot programs to encourage the use of shared appreciation mortgage modifications.

The bottom line is that recent developments may clear the way for more principal reductions, but it might not be so simple for borrowers. Lenders are likely to ensure that their interests are protected, which means they will be vigilant in ensuring that only borrowers who will default anyway would qualify for principal relief.

That might reduce the pool of borrowers who will benefit from this plan.

The FHFA's DeMarco has said before that he believes a potential 1 million borrowers could qualify for principal relief at the GSEs. This is not a number to be scoffed at, but not nearly large enough to make a significant dent in the housing market recovery.